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China Bad-Loan Alarm Sounded by Record Bank Spread Jump

Bad loans at banks including Industrial & Commercial Bank of China Ltd. have increased for six straight quarters through March 31, the longest streak in at least nine years. Photographer: Tomohiro Ohsumi/Bloomberg

June 28 (Bloomberg) -- Borrowing costs for Chinese banks
have surged the most in at least six years this month as rating
companies say a cash crunch threatens to swell bad loans.

The yield spread for one-year AAA bank bonds over similar-maturity sovereign notes jumped 56 basis points so far this
month to 163 basis points, the most in ChinaBond records going
back to 2007. The similar AA gap widened 59 basis points to 188.
Even as China Construction Bank Corp. President Zhang Jianguo
said yesterday cash conditions have normalized, the benchmark
seven-day repurchase rate was fixed at 6.85 percent, almost
twice the 3.84 percent average for this year.

Money-market rates touched the highest level last week
since at least 2003, prompting three of the largest rating
agencies to warn banks may run out of cash to pay investors in
their wealth management products and to extend new loans,
increasing the risk their customers will default. The People’s
Bank of China is seeking to wring speculative lending out of the
system after total credit approached 200 percent of gross
domestic product, according to Fitch Ratings.

“There could be unintended consequences from the central
bank’s approach,” said Liao Qiang, a Beijing-based director at
Standard & Poor’s. “We expect some deleveraging at banks’
interbank and wealth management businesses to unfold. Credit
growth would slow. This could pressure banks’ asset quality.”

Swaps, Bonds

The one-year interest-rate swap, the fixed cost needed to
receive the floating seven-day repurchase rate, touched an all-time high of 5.06 percent on June 20, according to data compiled
by Bloomberg. The one-day repo rate surged to a record 12.85
percent the same day, according to a daily fixing announced by
the National Interbank Funding Center.

The yield on 10-year government bonds rose 13 basis points
to 3.60 percent last week, while the one-year borrowing cost
jumped 51 basis points to 3.61 percent, inverting the so-called
yield curve for the first time in ChinaBond data going back to
2007. The 2023 yield closed at 3.53 percent yesterday.

Bad loans at banks including Industrial & Commercial Bank
of China Ltd. have increased for six straight quarters through
March 31, the longest streak in at least nine years.

Chinese commercial banks’ outstanding non-performing loans
rose 20 percent to 526.5 billion yuan ($86 billion) at the end
of the first quarter from a year earlier, accounting for 0.96
percent of total lending, according to data from the China
Banking Regulatory Commission.

Those figures don’t reflect the real amount of debt because
of the ways banks move loans off their books, Charlene Chu,
Fitch’s Beijing-based head of China financial institutions, said
in April. Some loans are bundled and sold to savers as wealth-management products, which pay more than regulated deposits, she
said. Other assets are sold to non-bank institutions, including
trusts, to lower bad-debt levels.

Increasing Risk

Non-performing loans may rise faster as weaker borrowers
have difficulty refinancing credit in the coming months, Moody’s
Investors Service warned on June 24. The official Xinhua News
Agency said in a June 23 analysis that risk is increasing in the
financial system as the shadow-banking sector expands and
institutions make more highly leveraged investments.

Shadow lending flourishes in China because an estimated 97
percent of the nation’s 42 million small businesses can’t get
bank loans, according to Citic Securities Co., and savers are
seeking higher returns. The industry may be valued at 36
trillion yuan, or 69 percent of gross domestic product, JPMorgan
Chase & Co. estimated last month. The crackdown may damage the
economy by shrinking funding for smaller companies, Barclays Plc
said on May 20.

Wealth Management

The nation’s outstanding amount of wealth-management
products rose by 500 billion yuan to 13 trillion yuan in the
first five months of this year, accounting for 16 percent of the
nation’s deposits, according to estimates published by Fitch on
June 10. That compares with a 4 trillion yuan increase for the
whole of 2012.

An estimated 1.5 trillion yuan of wealth management
products were to mature in the last 10 days of this month, Fitch
Ratings said June 21. Issuance of new products and borrowing
from the interbank market are among the common sources of
repayment for maturing products, it said.

Fallout from unofficial lending led more than 80
businessmen to commit suicide or declare bankruptcy over six
months in 2011-2012 in the southeastern exporting hub of
Wenzhou, a city of 9 million residents whose 400,000 small
businesses make products ranging from cigarette lighters to
eyeglasses.

Disorderly Unwinding

“The problem is that when debt levels have got so high,
and it’s more debt that keeps the existing debt afloat, you
absolutely have to stop the process, but it’s very difficult to
do so in an orderly way,” said Michael Pettis, a finance
professor at Peking University “There’s always a risk that the
unwinding of the debt becomes disorderly and the PBOC will be
blamed for mismanaging the process.”

About 563 new wealth products were issued last week, two-thirds more than the previous period, according to Benefit
Wealth, a Chengdu-based consulting firm that tracks the data.
China Minsheng Banking Corp., the nation’s first privately owned
lender, is marketing a 35-day product that offers an annualized
yield of 7 percent. China’s one-year benchmark deposit rate is 3
percent.

Mid-sized banks get an average of 20 percent to 30 percent
of their funds from such products, according to Fitch, which
didn’t name specific lenders. That makes these banks more
susceptible to default risks on the products.

New Curbs

The China Banking Regulatory Commission told banks in March
to cap investments of client money in debt that isn’t publicly
traded at 35 percent of all funds raised from the sale of wealth
management products. The next steps may include tightening that
sends some smaller financial institutions into bankruptcy,
according to analysts at Nomura Holdings Inc.

“What we will see over the next half year is credit growth
overall will slow down a bit,” Stephen Green, head of Greater
China research at Standard Chartered Plc, said in a Bloomberg TV
interview from Shanghai. “If interbank rates remain quite
volatile and at high levels, then that’s obviously going to have
a bigger feed through to credit.”

The PBOC’s decision to refrain from pumping “hefty” sums
into the financial system last week was a “bold but essential
move to discipline unchecked lenders,” Xinhua said in a June 26
commentary, adding that the pain is needed to pave the way for a
more sustainable economy.

Proactive Attitude

China Construction Bank president Zhang welcomed what he
called the PBOC’s “proactive attitude” to a changing market
situation.

“China Construction Bank hasn’t stopped new lending in any
sort of period, or to any sort of clients,” Zhang said at the
opening of a bank branch in Taipei yesterday. “Recently there
was a temporary liquidity squeeze condition, but CCB’s cash is
so adequate that we were able to lend money to our peers. The
cash shortage condition has eased in the last two days, and by
now the situation has already normalized.”

The central bank, which was silent during the worst of the
cash crunch, published a statement on June 24 saying there’s a
reasonable amount of liquidity in the financial system and that
banks should control risks from credit expansion, including
those associated with maturity mismatches.

Maintain Stability

The PBOC will use all kinds of tools to appropriately
adjust liquidity in the market and maintain the overall
stability, Governor Zhou Xiaochuan said at a forum in Shanghai
today. China will continue to implement a prudent monetary
policy and allow more foreign participation in the interbank
money, foreign-exchange and bond markets, he said.

“No policy maker can afford to be blamed for being
responsible for an unnecessary, fully-avoidable financial
meltdown and growth hard landing,” Bank of America Merrill
Lynch economists wrote in a report yesterday. “With a month of
mess in the interbank liquidity, it’s time to re-highlight
stability and it’s time for markets to calm down.”

The cost of protecting China’s government debt from default
slipped five basis points in New York to 116 yesterday and is up
29 basis points this month, according to prices from data
provider CMA. The contracts pay the buyer face value in exchange
for underlying securities or the cash equivalent if a borrower
fails to adhere to its debt agreements. The contract on Bank of
China Ltd. dropped 28 basis points to 165 yesterday and is 51
basis points higher for June.

“Smaller banks short of deposits will face significant
pressure from liquidity management,” said Zhou Hao, a Shanghai-based economist at Australia & New Zealand Banking Group Ltd.
“If the weakest link breaks, there’s an increase in the
likelihood of creating systemic risks.”